Why is raising interest rates a good idea for the Fed Reserve?

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I learned that low fed interest rates makes ppl borrow more, stimulating economy as money circulation is higher. why ever increase it then, if increasing it worsens the econ?

Also ,is the fed reserve actually the goveernment bank? heard it was still a giant private bank and the goverment has nothing to do with it

In: Economics

8 Answers

Anonymous 0 Comments

The Fed has to balance between two issues – economic activity and inflation.

Decreasing rates, generally speaking, increases economic activity – spurring investments, increasing employment (reducing unemployment), increases income etc. But the downside is that general price level increases (inflation)

Increasing rates, generally speaking, does the reverse.

However inflation is a dangerous thing. Some inflation is considered good (due to price/wage friction etc – beyond ELI5) but excessive inflation is bad. One reason is that high inflation also increases EXPECTATION for future inflation (eg if price rises 10% this year, many people expect prices will rise 10% next year) This means people might tend to hoard goods (rather than hold money) and/or move their assets out of the country which further increases inflation (so this is the inflation spiral)

Too high inflation affects producers, for example if you bake bread as a business, if the cost of flour increases too fast, by the time you sell your bread, you cannot afford to buy more flour. So you raise the price of bread – which leads to further inflation. Ultimately no one wants to produce because profits become uncertain. This then leads to more inflation and general shortage of goods. (see Venezuela recently for real world example) The entire economy starts to breaks down. Once this happens it is VERY VERY VERY difficult to recover from.

TL;DR The Fed wants to stimulate economic activity but cannot risk high inflation. Therefore it has to set interest rate to balance between the two.

Anonymous 0 Comments

Interest encourages people to use money rather than sit on it. If I have 100 I can buy 100 of goods or services. When interest rates rise, what used to cost 100 might now cost 105. I still have only 100, so my purchasing power has reduced. My money is worth less.

This encourages people to keep money in circulation rather than hoarding it, by investing it or spending it.

Anonymous 0 Comments

It’s an effort to minimize inflation. As the circulation increases, prices also creep up as demand rises due to the additional parties being able to afford more. That’s all well and good for those who are making more money, they can weather it, but the rest of the country struggles as they’re able to afford less and less on the same amount of money. A small bump in interest rates can encourage more saving and investing, slowing the circulation of money and thus demand, keeping inflation to a minimum.

Anonymous 0 Comments

Basically the federal reserve lends banks money at the cost of the paper its printed on, now in lending they give an interest so say they lent a dollar they want a dollar and one penny back, raising interest rates mean they earn more money on the return, at the end of the financial year, also raising the rates decreases how much is in circulation which in truth raises its value, correct me someone if I am wrong, but I’m pretty sure this is right.

Anonymous 0 Comments

On the plus side, lowering interest rates encourages borrowing; by businesses, for expansion, and people wanting to buy homes.

On the negative side, it makes it tough on people trying to grow their savings for retirement (or retired people trying to live on a fixed income, that includes their savings).

Anonymous 0 Comments

A couple things… it can cause inflation by flooding the economy with more money. It takes away a key tool the Fed has for trying to stimulate the economy in an economic downtown. And low interest rates hurt people’s abilities to safely save. Your savings account or CD is getting hardly any interest, in fact it isn’t even keeping up with inflation. That can drive some to seek higher returns in the stock market, but say you’re saving up a house down payment or are 80 years old and retired you can’t take on such risk and are falling further behind.

Anonymous 0 Comments

Lowering interest rates is an accelerator for the economy.

If you just keep pouring on the gas, the economy overheats and bad things start to happen. The main bad thing that the Fed is concerned with is inflation.

We also want to have some gas in the tank when we really need it, rather than just running pedal to the metal all the time. We’d like to be able to press the accelerator further when the economy is slowing down, but you can’t cut rates forever. The fed tends to increase rates when the economy is strong, and lower rates when the economy is weak.

Anonymous 0 Comments

The Fed has 2 primary mandates. Stabilize prices, and keep unemployment low. It accomplishes these with a variety of tools, but primary by controlling the Federal Funds Rate, which is the interest rates banks charge each other for short term loans. Other interest rates, such as auto-loans and business loans, tend to follow this rate.

When interest rates are low, inflation rises and unemployment goes down. When rates are high, inflation goes down and unemployment rises. To balance the two, the Fed adjusts the rates up and down as new data comes in to try and keep inflation at a low and stable level and keep unemployment from growing too high. If it kept rates too low, even as unemployment had effectively bottomed out, inflation would go up, meaning prices for everything are going up faster and are must less stable and predictable. So it must raise rates to keep inflation in check.